Stites & Harbison, PLLC

Facing a projected budget shortfall of approximately $1 billion, Kentucky Governor Steve Beshear has proposed a number of measures directed, at least in part, toward raising revenue for the Commonwealth. Governor Beshear's proposals include legislation that would (1) allow for Video Lottery Terminals to be operated at certain horseracing tracks, (2) create new tax credits, exemptions and incentives, and (3) provide additional funding for the Department of Revenue in an effort to enhance compliance and collection efforts. These proposals will be before the General Assembly, along with Governor Beshear's plan to address the projected budget shortfall primarily through the use of federal stimulus funds and further reductions in State services, in a special legislative session that began on June 15, 2009. Also before the General Assembly in the 2010 Regular Session will be two pre-filed bills that would bring about significant changes in Kentucky's tax laws.

Video Lottery Terminal Legislation

Governor Beshear's proposed legislation would authorize the operation of Video Lottery Terminals at approved horseracing tracks licensed by the Kentucky Horse Racing Authority. The proposal would allow for Video Lottery Terminals at seven locations throughout the Commonwealth — Turfway Park, Keeneland/Red Mile, Churchill Downs, Kentucky Downs, Ellis Park, Bluegrass Downs, and Thunder Ridge — although the ultimate decision would be subject to action by the local governments where the tracks are located. The tracks would be required to pay an initial application fee of $25,000 and an additional license fee ranging from $20 million to $100 million, a measure that would generate immediate revenue for the Commonwealth. Additional revenue would be raised through a tax imposed on net terminal revenue (i.e., the amounts wagered less payouts) at 25% for the first 5 years of operation and 35% for all subsequent years. Approximately 15-20% of the revenue generated from Video Lottery Terminals would be allocated to support equine interests in Kentucky, with the remainder used to bolster the General Fund.

The Video Lottery Terminal proposal also includes a number of seemingly-unrelated tax provisions: (1) an individual income tax credit equal to 50% of the state property tax paid on motor vehicles (not to exceed $500 per year); (2) an individual income tax exemption for all active duty military pay; and (3) sales tax exemptions for certain items purchased for the breeding, raising, training or transporting of horses.

The Video Lottery Terminal proposal is expected to be the subject of great debate during the special legislative session, with proponents insisting that the measures are necessary to allow the Kentucky horse industry to remain competitive with other states while opponents present a parade of horribles they believe will accompany expanded gambling in Kentucky. If passed by the General Assembly, the proposal will almost certainly face a constitutional challenge from its opponents, as the question of whether the Kentucky Constitution allows for Video Lottery Terminals is unresolved (and is the subject of conflicting Attorney General's Opinions).

Economic Development Tax Incentives

In addition to the tax proposals contained in the Video Lottery Terminal legislation, Governor Beshear is also promoting a number of income and sales tax incentives designed to encourage economic development in the Commonwealth. A number of the specific measures were approved by both the House of Representatives and the Senate in the most recent regular legislative session, but the session ended before final action could be taken to enact them into law. The proposed legislation includes a hodgepodge of economic development incentives and, according to a press release issued by Governor Beshear, "is designed to update the state's antiquated economic incentive toolbox with a focus on helping Kentucky's existing businesses, luring major tourism development projects to the state and securing necessary funding for a proposed advanced battery manufacturing complex . . ., all of which would create jobs and hundreds of millions of dollars in investment in Kentucky."

The highlights of the proposed legislation include all of the following:

• Consolidation of the existing "K-credits" (Kentucky Jobs Development Act, Kentucky Industrial Development Act, Kentucky Rural Economic Development Act and Kentucky Economic Opportunity Zone) into a single tax incentive program designed to give certain counties more flexibility in luring and retaining employers with at least 10 employees;
• Amendment to the Kentucky Reinvestment Act to allow certain manufacturers presently doing business in Kentucky to recover up to 50% of equipment costs and 100% of training costs, as an income tax credit, when upgrading facilities (Manufacturers would have to make a $2.5 million minimum investment and retain a certain percentage of employees);
• Expand the Kentucky Enterprise Initiative Act to allow electronic processing equipment purchases of at least $50,000 to become eligible for sales tax reimbursement;
• Establish a limited exemption from the pari-mutuel tax for particular horse racing events in an effort to lure the Breeders' Cup to Kentucky on a more regular basis;
• Allow for the recovery of up to 20% of approved film and theater production costs (in the form of an income tax credit) for documentaries, commercials, feature length films and Broadway productions, provided that the productions meet various minimum investment requirements; and
• Amend the Tax Increment Financing Program to, among other things, (1) allow previously undeveloped areas (as opposed to blighted urban areas) to qualify; and (2) reduce the minimum investment for Signature Programs from $200 million to $150 million (while precluding an applicant from receiving any increment financing until the minimum investment is satisfied).

Additional Department of Revenue Funding

Included within Governor Beshear's plan for addressing the projected revenue shortfall is additional funding for the Department of Revenue. The funding would be used to increase staffing by approximately 20%, bringing the number of employees from 786 to 1,000, with the goal of enhancing taxpayer compliance, increased billing and collection efficiency, greater audit capacity, and a reduction of interest paid on refund claims as a result of more efficient processing of claims. Governor's Beshear estimates additional revenue of $18.5 million for 2010 and $34.6 million for 2011 as a result of this measure. This proposal was presented by State Budget Director Mary Lassiter to the Joint Committee on Appropriations and Revenue on June 4, 2009. While no action was taken on the proposal at that time, it did garner bipartisan praise from individual members of the Committee.

Other Revenue Proposals

Also making headlines are two bills that that have been pre-filed for the 2010 Regular Session of the General Assembly—legislation from Representative Bill Farmer (R) and Representative Jim Wayne (D) that would substantially change Kentucky's tax laws. These proposals were presented to the Joint Committee on Appropriations and Revenue on June 4, 2009, with the sponsors offering brief presentations and fielding limited questions from Committee members. No evidence or outside testimony was taken by the Committee.

Rep. Farmer's proposal, 2010 BR 31, is the more dramatic of the revenue measures as it calls for the elimination of the individual and corporate income taxes and a reduction in the sales tax rate from 6% to 5.5%, with the loss in revenue recouped through the elimination of virtually all sales tax exemptions and the expansion of the sales tax base to include most services.

Rep. Farmer testified that BR 31 would generate $1.299 billion in additional revenue for fiscal year 2011 (As the sales tax changes would be implemented several months before the income taxes are phased out) and would generate approximately $96 million more in fiscal year 2012 than could be expected under Kentucky's existing tax laws. The basis for this latter projection is unclear. In response to questions from the Committee, Rep. Farmer conceded that he hoped his proposal could be a catalyst for a discussion of how to solve long-term budgetary problems through major tax reform.

Rep. Wayne's proposal, 2010 BR 2, offers more modest changes by rebalancing Kentucky's tax structure to place a greater burden on upper-income taxpayers. The specifics of Rep. Wayne's proposal include the following: (1) Extension of 15% the federal earned income tax credit to Kentucky taxpayers; (2) Restoration of the estate tax to all estates valued in excess of $1 million; (3) Increased income tax rate on the top 5% of taxpayers; and (4) Expansion of the sales tax base to services typically used by upper-income taxpayers.

While both proposals received a polite reception from the Committee, it is unclear whether the General Assembly will be interested in taking on major tax reform in the 2010 Regular Session, especially when Governor Beshear has developed a proposal to address the current budget shortfall without having to address the politically-sensitive tax issues. However, greater impetus for major change could occur if Kentucky's budget shortfalls continue after the federal stimulus money has been spent.

Ben Crittenden is an Associate in the Frankfort office where he represents businesses and individuals in their relations with and regulation by state and local governments, focusing on disputes involving state and local tax matters.